What Is Shadow Pricing?
The term shadow pricing is used to refer to either one of two things:
- The actual market value of a money market fund share even if it's stated value is $1 per share
- The assignment of a dollar value to an abstract commodity that is not ordinarily quantifiable as having a market price but needs to be assigned a valuation to conduct a cost-benefit analysis.
The latter instance is more common and involves a shadow price that is assigned to goods that are not generally bought and sold as separate assets in a marketplace, such as production costs or intangible assets.
[Important: Economists will often assign a shadow price to estimate the cost of negative externalities such as the pollution emitted by a firm.]
How Shadow Pricing Works
Shadow pricing as it relates to money market funds refers to the practice of accounting the price of securities based on amortized costs rather than on their assigned market value. Money market fund shares are always assigned a nominal net asset value (NAV) of $1, even though the actual NAV is usually slightly more or less than $1.
Such funds are required by law to disclose the actual NAV—the shadow share price—to show the fund's performance to investors more accurately. However, the use of the term "shadow price" in relation to money market funds is the less common usage. It is more frequently applied in the process of cost-benefit analysis in business decision making.
In its most common usage, a shadow price is an "artificial" price assigned to a non-priced asset or accounting entry. Shadow pricing is frequently guided by certain assumptions about costs or value. It is generally a subjective and inexact, or imprecise, endeavor. To make a decision regarding the undertaking of a project or investment, businesses often perform a comparative analysis of the project or investment cost against the projected benefits.
In performing a cost-benefit analysis, a business must often account for the costs or benefits of intangible assets that are difficult to assign a dollar value to but that must nonetheless be monetarily quantified for the purpose of performing the analysis.
- A shadow price is an estimated price for something that is not normally priced in the market or sold in the market.
- It is often used in cost-benefit accounting to value intangible assets, but can also be used to reveal the true price of a money market share, or by economists to put a price tag on externalities.
- Shadow pricing is inexact as it relies on subjective assumptions and lacks reliable data to fall back on.
An Example of Shadow Pricing
An example of shadow pricing as applied to a proposed business plan to renovate a company's office facilities might be the assignment of a dollar value to the expected benefits of doing the renovation. While the cost of the renovation can easily be assigned a dollar value, there are elements of the project's expected benefit that must be assigned a shadow price because they are not as easy to quantify.
The possible benefits of the project include the following:
- Improved employee morale
- Lower staff recruiting costs
- A lower employee turnover rate and increased productivity
Since it is impossible to assign a precise dollar value to such potential benefits, an estimated shadow price is assigned to set a dollar figure to compare with the cost figure.